401k Withdrawal Rules for Home Purchase 2022

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The minimum down payment required for a loan is the largest obstacle to buying a home. Even if you know your income is more than enough to support your mortgage payments, you may not have enough saved for the large 20% down payment that some mortgages require. Many people look at their assets and think taking money out of their 401(k) is a quick and easy method of meeting this requirement. However, there are many conditions and drawbacks to consider before withdrawing from your 401(k).

What is a 401(k)?

A 401(k) is a company-sponsored retirement account. It is called your 401(k) because the foundation for this savings plan is the 401K provision in the IRS code. Employees contribute part of their salaries, and some employers can match it. Instead of getting a constant interest rate, you must invest your 401(k) savings into securities (stocks, bonds, ETFs, REITs, etc.) to earn a return. 401(k) accounts have three main benefits to encourage people to make contributions.

1. Any income contributed to a 401(k) is not taxed
2. Any returns generated on investments from your 401(k) are not taxed
3. Employers may match contributions either partially or fully

However, these benefits do not exist without caveats. The government does not want your 401(k) to be a better tax-free savings account (TFSA). Instead, the government puts certain restrictions and penalties on early withdrawals to encourage long-term investing for retirement. These penalties include the 10% withdrawal fee for an early withdrawal. In addition to the fee, the withdrawn amount is subject to income tax. The following table can help you understand whether you can withdraw money without any penalty.

As an example of an early withdrawal penalty, suppose you need to withdraw $50,000 to cover the down payment. Because of the 10% penalty, the 401(k) balance will decrease by $55,000. Additionally, the $50,000 that have been withdrawn will be subject to income tax, so the owner of the account will have to also pay income taxes on these $50,000.

Can I use my 401(k) for a first time home purchase?

While the government discourages early withdrawals from your 401k, you can access the money in it using two different methods. You may either take out a 401(k) loan or make a 401(k) “hardship” withdrawal.

1. 401(k) Loans

A 401(k) loan is a “self-issued” loan, which means you borrow from your own 401(k) and repayments return to your account. Typically, the maximum loan term is five years, but this can be extended if the loan is used to buy a principal residence. With a 401(k) loan, you avoid the 10% early withdrawal penalty, and the amount will not be subject to income tax. The government does this because you have to repay yourself, so you are still saving for your retirement.

2. 401(k) "Hardship" Withdrawal

If your employer does not offer 401(k) loans, they may still offer a 401(k) withdrawal.

For people under the age of 59½, a “hardship” withdrawal or early withdrawal from your 401(k) is allowed under special circumstances, which are on the IRS Hardship Distributions page. Using your 410(k) for a down payment on a principal residence is classified as a hardship withdrawal. By opting to use a hardship withdrawal, you will have to pay the 10% early withdrawal penalty, and this amount will be considered taxable income. Exceptions are on the official IRS page. Generally, these exceptions are difficult to qualify for, so a 401(k) loan is usually better.

How much can you withdraw from your 401k for a home purchase?

The maximum withdrawal amount varies depending on the method you use. Start with a 401(k) loan because it is the financially responsible choice. You can cover any remaining fees with a 401(k) withdrawal because of the 401(k)’s stricter loan requirements.

Due to a recent congress ruling, if your employer allows it, you are allowed to withdraw both your employer’s 401(k) contributions and any investment earnings as well as your contributions.

Should you use your 401k for a home purchase

Your 401(k) should be the last place you look for down payment assistance. The government encourages you to keep money in this account to save for your retirement. Even with a 401(k) loan, you cannot make contributions for five years. The money in a 401(k) appreciates through investment returns. If you withdrew $20,000 out of your account today, with an annualized return of just 5%, you would be $86,000 poorer 30 years from now. There are also many other downsides associated with using your 401(k) for a home purchase:

• Early withdrawal penalties and increased taxable income
• Your 401(k) provider may charge you additional fees for early withdrawals or loans
• Since you cannot make contributions, you will lose out on any company matching programs that could double your contributions
• If you lose your job or quit, you will have to repay a 401(k) loan in full

Some homebuyers who cannot put a full 20% down payment are also offered an option to put less than 20% and take private mortgage insurance (PMI) instead. Since private mortgage insurance is paid by the borrower and protects the lender, many borrowers believe that they should avoid it at all costs. That is when they may think that it is better to withdraw money from their 401(k) instead of facing higher payments on the mortgage.

Even though sometimes it might be less costly to withdraw money from a 401(k), in many cases, it might be better to use PMI. PMI usually has an annual premium of around 0.5% to 1.5% of the principal amount. For example, a 1% PMI premium on a $300,000 loan is $3000 annually. It might sound like a lot, but PMI allows you to get a higher loan-to-value ratio. This means that the return on investment will be larger when using PMI instead of trying to find enough money to reach a 20% down payment. Additionally, the 401(k) tends to grow at a certain rate that depends on the investment portfolio in the account. An average growth rate of a market portfolio grows by 7% annually. Withdrawing the amount from 401(k) may lower the mortgage payments by around 1%, but you also do not earn interest of around 7% on the money withdrawn in addition to the 10% withdrawal penalty.

Alternatives to Using a 401(k) for a Home Purchase

You may not need a 401(k) loan or withdrawal to begin with. If your mortgage lender allows it, you can make a down payment of less than 20%. While a 20% down payment is standard, you only have to pay your minimum down payment. If your down payment is less than 20%, you get charged monthly Private Mortage Insurance premiums until you own 20% of your home’s equity. Generally, paying for these premiums is better than taking money from your 401(k).

Before using your retirement funds to pay for a down payment, consider any alternatives you have available: